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Sunday, 7 October 2012

German labour market: reform matters

It is often believed that the German labour market has much more nominal rigidities than the US market for example, which is supposed to be more flexible and hence more volatile. However a research by three German economists seems to show otherwise: “business cycle volatility of the labour market is twice as large in Germany than in the US.” They also find that Germany tends to have lower worker flows (longer worker-firm relationships), and point that these are mutually dependent. (see graph)

They do a comparison of the two countries’ labour markets from 1980 to 2004. Read the paper for technical details.

"Our recent research (Gartner et al. 2012) provides a model that shows that low worker flows and large labour market volatilities are two sides of the same coin. The reason is that low worker flows generate long-term worker-firm relationships. When the economy is hit by a persistent aggregate (productivity) shock, this has a larger effect on firms’ present values under long-term relationships. Why? Imagine an economy with one period worker-firm relationships (e.g. all workers quit after one period). In this economy, only the contemporaneous aggregate productivity changes are relevant for the firm’s contemporaneous behaviour. By contrast, if workers quit very infrequently (i.e. workers stay within the same firm for several periods), expected future productivity is also relevant, i.e. the present value of a firm is affected more substantially by a persistent shock. Thus, under long-term relationships firms hiring and firing reacts more sensitively to macroeconomic shocks."

How does this explain the relatively mild reaction of the German labour market compared to the US labour market during the Great Recession? The answer is in the labour market reform made in 2003 that initiated a period of wage moderation.

In another paper Gartner and Merkl (2011) compare two German recoveries, in 1974 and in 2008. The graph below summarizes the comparison.

"The 1974 recession hit Germany at a time of rising unit labour costs (i.e. real wages divided by productivity), while the Great Recession arrived at a time of wage moderation. We argue that the wage moderation in Germany is at the root of the German Miracle, potentially interacting with other measures such as the public short-time work scheme."

The fall in output was larger during the 2008 recession, but fall in employment was much worse in 1974. The reason for this, the authors claim, is in unit labour costs. They were rising in the begining of the 70-ies, but were falling steadily 5 years before the Great Recession. The labour market reforms initiated in 2003 made room for this wage moderation in Germany. The authors describe wage moderation as a positive permanent supply shock:

"...what we see in the data is Germany’s move to a higher permanent employment level which was interrupted by the Great Recession. Since firms saw a fall in their wage costs before the crisis, they could accept a temporary rise in wage costs during the crisis (anticipating that the crisis would be temporary) and afford to keep their workers."

As for the public short-time work scheme, the authors reject that it was the key to the recovery since it was also used to a similar extent in 1974 (3.6% of total employed were part-time workers in 1974, compared to 3.8% in 2008).

"Without the wage moderation before the Great Recession, the German miracle would have been impossible. This is a point that is often ignored in the German public debate. The German Hartz reforms, which made the unemployment benefit system less generous, were certainly one of the reasons for the wage moderation. The reform was initiated in 2002 by a governing coalition, led by chancellor Schröder and the ruling Social Democrats. For some reason the Social Democrats are currently ashamed of this reform. If only they were to look at the facts from the Great Recession, they would surely be proud."

Going back to the first set of graphs comparing the German labour market to the US labour market, can we conclude that Germany was undergoing reforms that didn't allow the aggregate demand shock to manifest itself on the labour market? The reason for this is purely accidental. Germany initiated the reforms in 2003 whose direct effects took place several years afterwards and acted as a buffer against the Recession. In that scenario, Sweden was no different. The reforms they initiated in 1992 made the system more robust to future shocks, one of which occurred in 2008.

Bottom line is that supply-side reforms were responsible for a quick recovery and a minuscule recession effect on the labour market.